What happens if the dollar hits $US1.20?

Date: November 26 2012

Matthew Kidman

Could the Australian dollar explode to $1.20 against the US dollar next year? The possibility of the local currency surging higher from the current elevated level is a scenario that is rarely contemplated by most financial analysts and traders. The consensus view is we have to get used to the Aussie trading close to parity or marginally higher for the time being because of the policies being adopted by the major central banks around the world.

However, this is a completely different story to the Aussie moving significantly higher. An appreciation of the local dollar would put the domestic economy and the Reserve Bank of Australia under enormous pressure.

The RBA has only afforded scant commentary to the dollar lately while working hard to keep a lid on things by accumulating $1.3 billion of foreign reserves in the three months to October. This would seem to have put a cap on Aussie of about $US1.04 for the moment. As we enter the new year, though, there is a strong chance the demand for the local currency could escalate despite softer mining commodity prices. If the Aussie does move higher the RBA will have to make some major decisions about the current level of interest rates and whether it throws in the towel and joins the game being played by the big boys - US, Europe and Japan.

Currencies are a relative game. The Australian dollar has remained stubbornly high in recent times and overvalued by most standards because its competitors have been merrily debasing their own currencies by printing unprecedented amounts of money. The US Federal Reserve has entered its third round of quantitative easing and this time the dollar figure has no ceiling. Similarly, the European Union has been forced to ramp up liquidity to avoid an implosion of its economic zone.

This global flood of liquidity may accelerate next year with the latest happenings in Japan. The world's third-largest economy is heading for an election in December and the odds favour the pro-inflation Liberal Democratic Party (LDP) winning the day. Led by former prime minister Shinzo Abe, the LDP has a central policy plank of not only defeating deflation but targeting an inflation rate of 3 per cent. This will require the Bank of Japan to up the ante and print a slew of yen. The yen has been the safe haven against the US dollar and euro in recent years and it is crippling the Japanese economy.

So what happens to the Australian dollar if the three largest currencies in the world are being devalued by massive increases in supply? It could well be that much of this has been factored in already and our dollar simply remains steady at current levels. However, if the RBA fails to cut official interest rates next month, global investors might ratchet up their buying of the Australian dollar. Despite being below historical averages, the yield offered by Australian bonds are still double their counterparts in the northern hemisphere.

That brings us back to our original question - what does the RBA do if the Aussie does start to march higher next year? The obvious response would be to cut official interest rates as the strong currency cruels a range of export industries including mining, education, tourism and agriculture. If the Aussie went all the way up to $US1.20 the domestic economy could simply grind to a halt. With official rates sitting at 3.25 per cent, the RBA could easily cut by another 150 basis points before it would have any major impact on the currency.

This type of monetary stimulus would have many consequences. Most obviously it would force investors to drain their cash balances in search of better returns. The beneficiaries in this set up would be the local share and housing markets. Both asset classes have enjoyed positive reversals of late with expectations of lower interest rates starting to be factored in. As we have seen in the US, a flood of liquidity has seen the stockmarket more than double in just over three years despite sickly economic growth. So for sharemarket investors it would be wise to watch the machinations of the currency in the next few months, especially after the Japanese election.

The RBA does not want to create any bubbles, though, particularly in the domestic housing market where prices are still well above historical averages. Easy money has created bubbles around the globe over the last two decades and the consequences have been damaging to virtually every man, woman and child.

So how do we avoid this scenario unfolding? It would seem the greatest hope for Australia is a sustained recovery in the US economy. Even though the Federal Reserve chairman, Ben Bernanke, has stated he wants rates to stay at the current low levels for several more years, a robust recovery in the economy would see investors buying US dollars for the inevitable rise in interest rates down the track. With housing starts in the US now in a full- blown recovery, it is feasible this trade may unfold next year. The odds of this happening would be enhanced considerably by a speedy solution to the fiscal cliff debate raging in Washington.

All this points to a captivating few months on global investment markets. Currencies will be a key.